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Hazardous close-ended mutual funds can destroy crores

Mutual fund industry does not enjoy the confidence of an aam investor, despite the fact that
- mutual funds are an excellent product per se and
- they have been in business for more than two decades now.

In my opinion, this is primarily due to their focus on the short-term profits for their business. They have rarely given thought to educating the investors which could provide a solid foundation to a long-term super-profitable industry... for everyone i.e. mutual fund companies, investors and the distributors.

They have done nothing to dispel the many myths prevailing about mutual funds. On the contrary, they have repeatedly played around these misconceptions to look after only their own interests, usually at the expense of the investors. That is why mutual fund industry has generally been on shaky grounds throughout its existence.

The latest example of this shortsightedness are the 80:20 Equity:Options Close-ended New Fund Offers.

As I have warned earlier also, close-ended funds can prove disastrous, especially now when the markets are not cheap. You can read my post 'With close-ended funds, mutual fund industry is inviting big trouble' to know all the pitfalls of such funds.

On top of this, they have added the "bomb" of Options into some of their latest close-ended equity NFOs.

a) Like any typical equity-oriented mutual fund scheme, they will utilize upto 80% of the corpus to buy stocks. This is fine.
b) Unlike in the past, they will utilize the balance upto 20% to buy Options of Nifty. This is not fine.

Without going into the mathematics of Options, let me explain why this is a terrible idea.

Buying Options means you make a profit if, after a pre-defined period (typically 3 years in this case), the Nifty quotes above the pre-defined value (in this case typically the present level of Nifty). This is where the problems arise.

Firstly, you are "betting" on the Nifty to be at or above a certain number after 3 years. If not, the "entire" 20% amount (which is paid as a premium to buy these Options) is lost. Instead, if this 20% were invested in stocks in the normal course, your loss would be only to the extent the stock prices are down; which is never 100%.

Yes, it is true that if the bet is "right", you will make more profits in these 80:20 equity:option combination schemes than the normal 100% equity schemes. This is where we have the second problem.

To buy these options you have to pay premiums. So the actual profits will happen only when the Nifty quotes at a level, which is higher than the present to the extent that it covers this premium cost. Going by current premiums, this break-even level is around 50%. In other words, the "extra profits" will start flowing in only if the Nifty is at 1.5 times the current levels or higher. If not, in such schemes, you would be a loser. Clearly, even for the aggressive investors, the risk-reward ratio is extremely poor.

Moreover, just imagine if the markets were down even for that one crucial day, when the Options mature. Then you lose the entire 20% of your money. Mutual funds companies have no business to play "lottery" with our money.

So, given that the trigger is a particular level of Nifty on a particular date, this is nothing but a Time-Bomb ticking... tick tock.. tick tock... tick tock...

... there is no need for mutual fund companies to launch close-ended schemes, if they really value investors' interest
... they should avoid betting as they are in the business of equity "investing", not equity "trading".

An Investment In Knowledge Pays The Best Interest ~ Benjamin Franklin

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